Markets & Finance

Stocks: Is October Really That Scary?

October has seen some ugly market action in past years, but the S&P 500 has actually posted an average gain for the month since WWII

From Standard & Poor's Equity ResearchThe disappointing August employment report, released Sept. 7, sent the Federal Reserve into action less than two weeks later. The Fed slashed both the discount and Fed funds rates in a Zorro-esque single stroke, thereby reducing Standard & Poor's expectation for a recession in the coming 12 months to 33% from 40%. Other investors felt the same way, in our opinion, as they were willing to bid up equity prices during September despite worries over an encroaching recession. (The strength certainly carried over into the first trading session of October.)

For the month, S&P's large-, mid- and small-cap indices posted increases of 1.4% to 3.6%, while nine of 10 S&P Composite 1500 sectors also gained for the month. Energy and Materials were the best performers, as oil prices broke above $80 per barrel, and worldwide economic growth prospects received a boost from lower short-term interest rates, thus rekindling upbeat prospects for rising demand for basic materials. The Consumer Discretionary sector declined 1.1%, however, on a likely continuation of concerns surrounding the housing slump's potential impact on consumer confidence and spending patterns.

With September out of the way, what's left to fret? Investors have been spooked by October's reputation—not because of Halloween—but because it has been a bottoming month for many market meltdowns: Five of the last nine bear markets in the past 50 years ended this month. It also hosted the granddaddy of all crashes, in 1929, and a pretty fair-sized "market break" in 1987. Yet, since 1945, the S&P 500-stock index posted an average increase of 1.1% during October (vs. an average 0.7% gain for all months), a performance that surprises many.

S&P's Investment Policy Committee expects the S&P 500 to close 2007 at 1560, about 2% above the recent 1525 level and 10% higher than 2006's closing value of 1418. Factors that S&P thinks will contribute to a modest upward trajectory in share prices during the rest of the year include: 1) at least one more cut in the Fed funds rate, likely to 4.50%, at the Oct. 30-31 FOMC meeting; 2) third-quarter S&P 500 operating earnings that, if the pattern of beating expectations persists, will come in stronger than the current 2.4% estimate; and 3) a continued weakening of the U.S. dollar, which may further aid operating earnings, as S&P Index Services estimates that 45% of revenues for companies in the S&P 500 come from overseas operations.

Another reason for our modest rest-of-year optimism is that we have now entered the fourth quarter—traditionally the strongest of the year. Since 1945, the S&P 500 has advanced 4.1% in this final three-month stretch, vs. gains of 2.3%, 2.0%, and 0.3% for quarters one through three, respectively. What's more, the S&P 500 has risen during 79% of all fourth quarters since World War II.

Since 1990, which is as far back as S&P GICS (Global Industry Classification Standard) sector-level data extend, the S&P 500 gained an average 6.5% during the fourth quarter. While seven of 10 sectors posted average advances in excess of the market's average return, only the Consumer Discretionary group's 65% frequency of market outperformance was better than a random coin flip. Energy issues, on the other hand, were quite weak in this final quarter, registering only a 1.8% price advance and beating the market only about one in every three years.

Subindustry standouts included Electrical Components & Equipment, Electronic Equipment Manufacturers, and Multiline Insurance, each besting the market 75% of the time, and posting fourth-quarter average advances in excess of 9.8%. Perennial underperforming groups were Food Retail, Gold, and Oil & Gas Exploration & Production, which outperformed the broader market only 25% of the time.

Even though many of these price changes and frequencies of outperformance and underperformance may be eye-catching, please remember that past performance is no guarantee of future results. But average single-quarter performances do not a strategy make. We continue to recommend that investors overweight the Energy and Information Technology sectors, while underweighting the Consumer Discretionary group.

Regarding energy, we recently raised our yearly average 2007 West Texas Intermediate oil spot price forecast to $68.68 per barrel and 2008's forecast to $74.25, reflecting elevated global demand growth projections, combined with a rising OPEC share of projected supply. Our overweight recommendation for IT is based on our belief that the sector will benefit from above-average EPS growth prospects and international revenue exposure.

Consumer Discretionary stocks, however, should underperform the overall market, in our opinion, as a result of a weakening economic environment, continued housing weakness, and high relative valuations.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of 5 (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).